The biggest mistake investors make when analysing dividend income stocks

This is a mistake that most dividend-seeking investors make. They think analysing income stocks is the same as growth stocks.

It’s an understandable mistake as many brokers tend to use much the same jargon and approach when making a recommendation on an ASX stock, regardless of what type of stock it is. This is why retail investors don’t think they need to change their approach when looking at a stock for its dividend or growth appeal.

But that’s a big mistake. There’s a saying in the market that a credit analyst cannot be an equities analyst, and vice versa, because the two are trained to think differently when looking at a security.

Income vs. Growth

A credit analyst is one that looks at bonds and other forms of debt investments that pay a regular dividend. You can probably start to see why credit has more in common with an income stock – and it’s a point of distinction that many people miss.

Broadly speaking, equities analysts focus on the risks to growth and would put a “buy” recommendation on stocks which they are relatively confident can increase their earnings over the medium to longer term.

This is largely true even when it comes to income stocks that are favoured by investors wanting a consistent dividend over capital growth.

What’s more, their price target on a stock is more often than not based on discounted cash flow calculations and/or a price-earnings multiple benchmark – both of which do not pay much heed to the quality of the dividend.

On the other hand, credit analysts don’t care about risks to growth. They are instead focused on the risk of not being paid and this is why they are preoccupied with things that threaten the stability of cashflows and not threats to earnings growth.

In other words, equity analysts look at the upside while their credit counterparts only look at the downside.

It’s not EPS but CPS

I am not saying income stocks are perfect substitutes for credit as there are several distinct differences between the two asset classes, but what I’ve observed is that those looking a income stocks do not focus enough on the key metrics that are important to sustain dividend payments.

For instance, many investors compare earnings per share (EPS) to dividend per share (DPS) when assessing the sustainability of a dividend. Payout ratios are calculated on this basis, but I’ll talk about that in the next section.

EPS isn’t a particularly useful metric for income investors in my view because EPS doesn’t reflect the cash flow from the business, and a company can only pay dividends from cash – not profit!

Confused? One of the key things income investors must understand is that cash flow and profit are not the same thing. Profit can be impacted by non-cash factors such as depreciation, amortisation, and asset revaluations.

If deprecation and amortisation were to fall, a company’s profit would suddenly shoot higher but it doesn’t mean the company has received extra cash.

The same is true when asset value changes. This could be due to an increase in the company’s properties or write-downs/impairments. Again, no cash changes hands.

This is why I prefer to use operating cash-flow per share (CPS). Operating cash flow is the amount of cash a company receives from selling its goods and services, minus the direct costs for servicing its clients (i.e. wages, cost of goods).

I want to see the CPS comfortably above the DPS if I were thinking about buying a stock for its dividend. Whether the EPS is above or below the DPS is secondary to me.

The problem is CPS is not readily available compared to EPS. A company’s accounts will report EPS but it seldom prints the CPS.

There’s an easy way to work this out. If you look at the company’s cash flow statement, it will say what the net operating cash flow is. If you look further down under “cash flow for financing activities”, it will state what the total dividends paid is for the period.

Just divide the dividends paid with net operating cash flow to work out the ratio. The lower the number, the safer the dividend. The ratio needs to be below 1 or it means the company pays out more in dividends than it gets in cash.

Why you should still look at the payout ratio

I know I said it isn’t that useful to look at the EPS and the EPS is used to calculate a company’s payout ratio (which is the proportion of its net profits used to pay dividends).

But this doesn’t mean it’s totally useless. The EPS and payout ratio are readily available, and they often provides a good first-take on how much wriggle room there is for a company to keep its dividend.

The rule of thumb is 80% (although it does vary between sectors). If a company has a payout ratio well below 80%, I have some confidence that it can maintain its dividend payment even if profits were to fall in the next period.

Just don’t rely solely on the payout ratio to build your investment case.

Looking for leverage

The third thing income investors should scrutinise more than growth investors is gearing and repayment schedules.

There are a few ways to calculate gearing and most people use net debt to equity as a guide. You will use the “balance sheet” section in the accounts to work this out.

You first add “interest bearing liabilities” or “borrowings” from current liabilities with those in the non-current liabilities. Then you subtract the cash and cash equivalents listed on the balance sheet. If the number is negative, you don’t have to do anything more as the company has effectively no debt.

If the number is positive, you will divide the number with “total equity” to work out the percentage. What is considered conservative can vary substantially between sectors but most experts would agree that below 70% is reasonably conservative in most cases.

Companies that are highly geared are more likely to cut their dividends when times get tough compared to those with little or no debt.

But you shouldn’t stop there. You should dig into the notes of the accounts to find out when the debt matures. If there is a debt facility that must be repaid (or rolled over) within the year and the facility plus forecast CAPEX in the next period is 75% or more of its cash balance, you want to find out how the company intends to repay the debt before deciding to bank on its dividend.

Happy investing fellow Fools!